A Democratic Senate: First Thoughts/Economic Outlook
Jude Wanniski and Alan Reynolds
November 11, 1986



The good news: Any ideas about budget-cutting welfare reforms are out the window with a 55-45 Democratic Senate. Indulging the Domenicis and Doles in RR's last two years would not be good for the economy or the GOP. This means stalemate on fiscal issues, no "package deal" of domestic cuts and tax increases.

The bad news: Protectionism. Although the Dems didn't campaign as protectionists, they will act as if they did. The 100th Congress will confront RR with a modern Smoot-Hawley, which he will veto, but which may be overridden as frightened Republicans head for the hills. This is the greatest threat to the economy in the year ahead. The only escape avenue the White House has, to take the edge off the protectionist threat, is monetary reform which we hope it soon realizes. Think of Tuesday's elections as parallel to the 1926 off-year elections, in which Democrats did not challenge the popular Coolidge or his programs, but began the groundwork over farm economy problems that led to Hoover and Smoot-Hawley.

Jude Wanniski


Weakness has been mainly in inventories and mining not trade or manufacturing. The drop in the savings rate means income is being deferred to get next year's lower tax. Japan's lower discount rate lowers U.S. bond yields, and adds new pressure on Germany to ease. Both Germany and Japan will adopt tax reforms that will be better and sooner than expected.
September's revival of factory orders, leading indicators, housing and exports looks encouraging, as does the October purchasing agents survey, showing increased orders and production. This may yet turn out to be the longest and strongest expansion of the postwar period. Indeed, the average growth rate of real GNP over the past 15 quarters (4.2%) already exceeds the first 15 quarters after the 1960 recession (3.6%). Over half of the "Blue Chip" forecasters do not expect a recession before 1989, if then.

When mining (e.g., oil drilling) and utilities are subtracted from industrial production, manufacturing output rose at a 4.8% annual rate during the third quarter, and manufacturing productivity rose at a 4.2% rate. Compared with a year earlier, real investment was up 8.9% in housing, 8.4% in consumer durables, and 5.3% in business equipment.

The biggest setback in GNP over the past two quarters, as in 1985, was not increased net imports, but weakness in business inventories. Businesses do not accumulate inventories while prices are expected to fall. In the third quarter, running down inventories subtracted $19.6 billion from GNP (in 1982 dollars), compared with only a $10.7 billion subtraction due to net imports (largely oil).

Real final sales GNP minus the inventory swing rose at a 4.6% rate in the third quarter, while real exports were 4.8% higher than a year earlier.

Even if the trade gap remains as wide as it is (which is quite unlikely), simply getting inventories back in line with final sales would generate much faster growth of real GNP -- without any acceleration in other components of GNP. Global recovery of prices and profits in deflated sectors (raw materials) would push growth rates still higher, adding inventory and fixed investment in those sectors.

The prospect of lower tax rates next year is delaying reported income but not purchases. Personal income supposedly rose at an annual rate of only $18 billion (compared with $51 billion in the second quarter), while personal taxes rose by $14 billion. With taxes absorbing nearly all of the increase in reported income, it is little wonder that the measured "savings rate" dropped from 5.1 to 2.9%. This does not mean consumers are overextended, or that we are "A New Generation of Non-Savers," as The New York Times theorized on November 2. Instead, the literally unbelievable slowdown in personal income shows that taxpayers are delaying receipts until tax rates drop. Reported profits may likewise be delayed.

Those who had incorrectly predicted collapsing consumption came up with the excuse that consumer durables are being purchased at the expense of next year, to get the sales tax deduction. Yet hardly anyone itemizes sales tax deductions (except for autos), so the deduction is the same whether taxpayers buy more or less than the tax tables assume. Repealing the deduction has no effect on purchases. For autos, the sales tax deduction is a trivial part of the cost.

Since Japan cut the discount rate, the Bundesbank is under even greater international and domestic pressure to ease. With a wider gap between European and Japanese interest rates, European currencies will rise against the yen. Germany's trade surplus rose 28% in September, which is not an internationally tolerable source of further "growth." The German government does not want to do anything before the January 25 elections, but the Bundesbank is relatively independent and could act sooner. Germany's wholesale prices have fallen 8.1% over the past year. Real retail sales are 1.5% lower than a year before, and manufacturing orders are down 0.8%. On October 20, Germany's five leading economic research institutes urged that planned tax cuts for 1988 be accelerated to January 1987, and German officials are talking about doing more "real tax reform" explicitly noting the growing percentage of taxpayers in higher tax brackets.

The Fed will naturally feel more comfortable with the dollar and bonds up, and gold down, but will not cut the discount rate right away. Reduction of foreign interest rates raises the demand for dollar bonds, due to relatively higher yields and reduced exchange rate risk. The firmer dollar weakens commodity prices in dollars, alleviating inflation anxieties. The yield curve will flatten.

Japan's latest interest rate cut may not be the last, unless rapidly reinforced by tax reform. Japan's wholesale prices in September were down 11.8% from a year earlier (and down 16.3% since October 1982), with an even sharper decline in export prices. Manufacturing orders in August were down 14% from a year earlier, and industrial production has fallen 2.7% over the year. Capital spending in manufacturing is expected to fall 6.1% this year. Coincident and leading indicators are down in Japan (also Australia), suggesting recession not merely "sluggishness."

In early October, Japan's Finance Ministry submitted a proposal to cut the top tax rate from 70% to 50% in fiscal 1987, albeit with some unwise trade-offs such as higher capital gains taxes and a VAT, which dropped Tokyo stock prices by 10%. Discouraging Japanese purchases, with a value-added tax, is no way to substitute domestic growth for excess dependence on exports. Expect something better to ultimately emerge from Finance Minister Miyazawa, whose influence just rose with the yen-dollar stabilization. Competitive tax rate reduction looks favorable for 1987-88.

Polyconomics Forecast for the "Blue Chip" Survey, November 1986:

                                                                                1986                      1987                      1988

Real GNP                                                                2.7                         3.8                          4.5%
GNP Deflator                                                          2.6                         2.7                          3.0
Consumer Prices                                                 1.7                          2.9                          2.7
Industrial Production                                          1.0                          3.9                          5.0
Disposable Personal Income                            3.5                          3.7                          4.8
Nonresidential Fixed                                          -0.6                          6.5                          9.5
Pretax Profits                                                         7.4                        14.0                         16.0
 (with IVA & CCA)
3 mo. Treasury Bill                                                5.8                          5.8                           6.0
Aaa Corporate Bond                                            8.8                          8.2                           7.8
Unemployment                                                      6.9                          6.6                           6.0
Housing Starts                                                       1.9                         1.85                         2.0 mn.
Domestic Auto Sales                                            8.0                          7.7                          8.2 mn.
Auto Import Sales                                                  2.9                         2.8                           3.0 mn.

Alan Reynolds